You Can Avoid the High-Frequency Traders

Michael Lewis has set off quite a storm about high-frequency trading. His new book, Flash Boys: A Wall Street Revolt, attacks the practice rather vigorously and has renewed the discussion about the high-frequency trading firms. I downloaded the book this morning and have not read it yet, but I have seen the reviews and excerpts, and he is clearly positioning the high-frequency trading folks as evil profiteers.

I have had a lot of discussion with people about this topic over the years, and it is clear to me that high-frequency trading does change the nature of markets (see Rev Shark's great piece on it this morning) and that money is coming out of the pockets of individual and institutional investors.

I can't be so quick to call this practice evil. It is legal under the current regulations. If I were smart enough to find a way to legally rig up my computer to make tens of millions of dollars, I would do it in a heartbeat. So would you. I have met some of the people who engage in high-frequency trading, and the entire practice strikes me as Revenge of the Nerds, Wall Street Style.

My biggest concern with high-frequency trading is that legislative bodies will use it as an excuse to enact a transaction tax to protect the individual investor. All that will do is transfer that .0001% or so of each trade from the high-frequency trading firms to the government, and the government will not be content with its share, and the tax will go up over time.

No matter what rules, regulations or taxes are devised to halt this type of trading, someone will find a way to game the new system within the laws as written. There is way too much brain power and computing power for that not to happen. However, if individuals would just choose to exercise their biggest advantage over Wall Street, it would never been an issue for them. Any high-speed trading program needs to trade in the big, liquid stocks, exchange-traded funds and indices. You can avoid all this angst and pocket-picking algos by investing in smaller stocks over a longer time frame.

I do not have to worry too much about high-frequency trading when I am buying 500 or 1,000 shares of a $30 million market-cap bank. It may take me a few hours or sometimes even a few days to get my order filled, but since I am buying it at 75% of book and plan to hold it for years, I do not care that much. I do not need to be able to hit the bid or lift the offer for millions of shares at a time, so I do not need to invest in the large liquid stocks such as IBM (IBM) or Google (GOOG). I am buying safe and cheap, so I am not hovering over the keyboard waiting to hit "sell" if the stock drops a penny, so I can be a patient seller.

I was having this discussion with some friends after The New York Times published the excerpt from Lewis' book over the weekend. One friend pointed out that this was all well and good for me, as I am a value guy. He said it was a different story for investors who prefer growth stocks. I broke out a screener and showed him that this was not the case at all. In fact, the individual who invests in growth stocks would probably be much better off going small.

There are 86 stocks right now that have less than $300 million total market capitalization that have grown earnings at 20% or higher for the past five years, one year and latest quarterly comparison. There are some interesting companies on this list that should appeal to growth-oriented investors. There is a wide swath of industries and sectors on the list, so even growth investors should be able to get smaller and avoid the manipulation that may occur with more liquid stocks

Consider Shiloh Industries (SHLO) a company that provides "lightweighting" and noise, vibration and harshness solutions to the automotive, commercial vehicle and other industrial markets. The company has grown earnings at an average of 25% over the past five years and posted profit gains of 58% in the past year. That sounds like a growth stock to me. The market cap is just $299 million, and the daily trading volume is just 135,000 shares. That is not enough to attract the high-frequency trading crowd, but a growth-stock-oriented individual should be able to fire off 1,000 or 2,000 shares easily.

Individuals who insist on dealing with the largest most well-known stocks place themselves at the mercy of high-frequency and computerized trading. Even if high-frequency trading as it exists is regulated, something will replace it in short order. You can find better opportunities and avoid the algos by looking at the smaller stocks.